Review and Outlook Markets moved higher in the first half of 2014, despite an early sell-off in heavily-owned hedge fund names and popular technology stocks. While investors perceived the market as volatile, the +7% return for the first half largely exceeded expectations.

In the U.S., the Second Quarter’s strength was magnified by the rebound from poor weather that depressed Q1 results. Despite strong recent data on jobs and manufacturing, it remains unclear whether growth will be robust enough to merit tightening action by the Fed this year. We believe we are entering a decisive period and normalized Third Quarter economic growth will mark a key inflection point.

Until then, anticipating a rate hike has been like waiting for Godot. If growth is approximately 3% during the second half of this year, we expect the market will look to the Fed to take action in early 2015. If growth moves closer to 2%, the Fed is likely to remain on hold for longer. While typically markets have applauded that course of action, at current S&P multiples, lower growth could instead cause a modest de-rating as corporate earnings growth will likely disappoint. Our profits this year have been led by corporate and structured credit investments which have generated two to three times the returns of their indices and peers. Our U.S. equity portfolio’s return has been slightly ahead of the S&P 500 index’s performance. Relatively small investments in Latin America have been exceptional performers.

Exposure to Japan has been our biggest source of losses in 2014. A strong year-end rally and frustration over the pace of reforms caused the Japanese markets to correct by more than 10% in the First Quarter. Our team’s trip to the region in May and meetings with senior officials confirmed that the desire for reform is acute and widespread. Though Prime Minister Abe and other leaders appear committed to changing Japan, shifts of this magnitude do not happen overnight. Moving a country from a culture of persistent deflation to an inflationary environment will only happen slowly. We are seeing early signs that the government’s growing support for improved corporate governance and increased focus on shareholder returns is impacting Japanese companies, a few of which have adopted measures addressing these areas recently. We continue to find compelling individual situations in Japan and, while each has an event-driven component, we recognize that the macroeconomic backdrop will factor significantly in the outcomes of these investments. We think recent macro headwinds will become tailwinds again towards.

Review and Outlook

Markets moved higher in the first half of 2014, despite an early sell-off in heavily-owned hedge fund names and popular technology stocks. While investors perceived the market as volatile, the +7% return for the first half largely exceeded expectations.

In the U.S., the Second Quarter’s strength was magnified by the rebound from poor weather that depressed Q1 results. Despite strong recent data on jobs and manufacturing, it remains unclear whether growth will be robust enough to merit tightening action by the Fed this year. We believe we are entering a decisive period and normalized Third Quarter economic growth will mark a key inflection point.

Until then, anticipating a rate hike has been like waiting for Godot. If growth is approximately 3% during the second half of this year, we expect the market will look to the Fed to take action in early 2015. If growth moves closer to 2%, the Fed is likely to remain on hold for longer. While typically markets have applauded that course of action, at current S&P multiples, lower growth could instead cause a modest de-rating as corporate earnings growth will likely disappoint.

Our profits this year have been led by corporate and structured credit investments which have generated two to three times the returns of their indices and peers. Our U.S. equity portfolio’s return has been slightly ahead of the S&P 500 index’s performance. Relatively small investments in Latin America have been exceptional performers.

Exposure to Japan has been our biggest source of losses in 2014. A strong year-end rally and frustration over the pace of reforms caused the Japanese markets to correct by more than 10% in the First Quarter. Our team’s trip to the region in May and meetings with senior officials confirmed that the desire for reform is acute and widespread. Though Prime Minister Abe and other leaders appear committed to changing Japan, shifts of this magnitude do not happen overnight. Moving a country from a culture of persistent deflation to an inflationary environment will only happen slowly. We are seeing early signs that the government’s growing support for improved corporate governance and increased focus on shareholder returns is impacting Japanese companies, a few of which have adopted measures addressing these areas recently. We continue to find compelling individual situations in Japan and, while each has an event-driven component, we recognize that the macroeconomic backdrop will factor significantly in the outcomes of these investments. We think recent macro headwinds will become tailwinds again towards year-end but remain vigilant about inaction. A failure of Abenomics would likely mean that it is time to move on.

Looking ahead, we expect market volatility to continue. After increasing exposure in May, we recently sold down some positions and are focused on several larger new ideas. We are agnostic about geography and sector. Credit exposures should remain steady and we will continue to be highly selective when initiating new opportunities. We believe that having dry powder on hand will be increasingly useful towards year-end.year-end but remain vigilant about inaction. A failure of Abenomics would likely mean that it is time to move on.

Looking ahead, we expect market volatility to continue. After increasing exposure in May, we recently sold down some positions and are focused on several larger new ideas. We are agnostic about geography and sector. Credit exposures should remain steady and we will continue to be highly selective when initiating new opportunities. We believe that having dry powder on hand will be increasingly useful towards year-end.

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